Here's how the Federal Reserve will actually raise interest rates

After keeping its benchmark interest rate pegged in a range of 0%
to 0.25% for seven years, the
Fed announced that, starting on Thursday, December 17, it
would target a new effective rate between 0.25% and
0.50%.

So with this, the Effective Fed Funds rate will likely move from
around 0.13% to around 0.38%.

In a
press conference following the Fed's decision, Chair Janet
Yellen emphasized that this still puts the Fed on very
accommodative footing as it looks to support the current economic
recovery.

But how the Fed will raise rates after seven years with rates
near 0%, in addition to three separate rounds of quantitative
easing — or purchasing bonds outright — which added around $4
trillion to the Fed's balance sheet, is not as easy as just
saying "rates are higher."

What the Fed is doing by raising rates into a range is
targeting a new Effective Fed Funds that falls in the middle
of this range.

This range, then, sets a floor on what are known as reverse repo
operations and a ceiling on interest paid on excess reserves held
at the Fed by banks.

Reverse repo operations are transactions the New York Fed carries
out in the market with money-market mutual funds and other
dealers, where cash on these funds' balance sheets
is swapped for Treasuries held by the Fed in overnight
transactions.

Think of this as the mechanism that "pushes" interest rates
up. Previously, the Fed's repo floor was 0.05% — not the 0%
implied by the prior Fed target range — so if you want to be a
lot of fun at a holiday party, tell your friends the Fed never
had rates at 0% and you'll be technically right.

The Fed began testing the reverse repo facility last year in
anticipation of a Fed rate increase. This program was initially
capped at $300 billion daily. But on Wednesday, the Fed
removed this cap as works to actually raise interest
rates for the first time with this program in place, and with
this many excess reserves sloshing around the banking system.

In a separate statement on Wednesday, the
New York Fed said that up to $2 trillion would be available
for reverse repo operations.

The upper-band of the Fed's new interest rate corridor
affects the interest on excess reserves, or IOER, held at
the Federal Reserve. Simply stated, excess cash parked at the Fed
by banks will now earn a little more than it did previously,
0.25% more to be exact. Think of this facility as "pulling"
rates higher.

In a note to clients last week, analysts at Bespoke broke down
what this will sort of look like.

Bespoke

In addition, the Fed's targeted corridor to goose up the
Effective Fed Funds rate, the Fed also announced an increase in
its discount
rate to 1% from 0.75%. The discount rate is what
banks pay for money borrowed from their regional Fed bank
branch.

A number of banks have also announced
that their "Prime Rate" would be increased to 3.5% from
3.25% in response to the Fed's action.

Things like credit-card and small-business loans are benchmarked
off of this rate.

So while the big news on a Fed rate hike crossed on Wednesday,
Thursday is when we'll get to see, for the first time, how the
Fed's new tools work.